EUR Reacts to ECB's Dovish Hike, Now More Influenced by the USD

EUR: Driven even more by the dollar after dovish ECB hike

The ECB delivered a 25bp rate hike yesterday but added a paragraph in its statement that quite clearly hinted this should be the last move of the tightening cycle. That paragraph, which President Christine Lagarde re-read multiple times during her press conference, says ECB rates have “reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target”.

A data-dependent approach was reiterated, but it is now looking more likely that will be used to judge how long rates will be kept at such restrictive levels, rather than to decide whether to add another hike before reaching the peak.

We had discussed the asymmetrical downside risks for the euro yesterday, and those fully materialised. With a full 25bp hike already in the price by year-end, the ECB had to move away from dovish language to support the euro, while quite the opposite happened. We think that at this stage EUR/USD will revert to being even more driven by the dollar leg. Markets have taken on board the notion that the ECB has likely peaked, meaning that data releases in the eurozone should lose some degree of market relevance. Lagarde has probably switched from a near-term hawkish narrative to defending a higher-for-longer approach to combat inflation: expect some pushback against rate cut speculation if eurozone data deteriorate further.

On the other hand, another Fed hike isn’t fully to be ruled out (although it is not our base case) and markets have had to reprice Fed rate cut expectations quite substantially of late on the back of resilient US economic data. Expect EUR:USD short-term rate differentials to be an even closer function of US activity prints from now on.

We could see EUR/USD inch back higher today, but a return to the 1.0600/1.0650 area around the Fed meeting seems appropriate.

Francesco Pesole